With the enactment of new tax legislation at the end of 2015 that made the research and development (R&D) tax credit permanent, there is renewed focus on credit claims by both taxpayers and taxing authorities alike. This is an area of tax law that has gone through continuous change over the past 10 years, including various interpretations of which taxpayer activities and costs qualify as “research and development” for purposes of the credit.
In February 2016, the IRS provided its annual list of the “Dirty Dozen” tax scams for the 2016 filing season. The list included the R&D tax credit, citing significant misuse resulting from inaccurate and improperly substantiated claims. This has increased the expectation that the taxing authorities, which have already been very aggressive in reviewing and analyzing the taxpayer’s R&D project documentation and accounting records, will become even more active and aggressive in auditing credits claimed. Moreover, both the IRS and state tax authorities continue to aggressively challenge a taxpayer’s use of estimates in their R&D calculations and have increased their requests for project and personnel narratives. These narratives must explain the qualifying nature of the employees’ activities, as well as the qualifying nature of each project (including analysis and explanations regarding expenses that were excluded).
It is important to note that even a partial IRS disallowance of a taxpayer’s claimed R&D costs can have a significant impact on the taxpayer’s income tax liabilities, as the IRS adjustment not only affects the year(s) subject to audit, but also each tax year for which the statute of limitations has not expired.
Currently, the IRS’ first Information Document Request (IDR) issued to the taxpayer in connection with an audit of the R&D credit includes 19 request items, including:
- Requests for research expenses by projects for both the current year and the base years
- Explanations on how employees were qualified and quantified, including providing total expenses that rely on oral testimony
- Copies of interview records related to claim qualification and quantification efforts sufficiently detailed to identify facts and circumstances surrounding interviews
- Explanations of how the various new and improved business components being developed during the year(s) qualify for the credit
- Detailed calculations that include the historical information associated with the fixed base percentage and base amount and how the consistency requirement under the statute was met
In order to minimize the time, cost, and effort associated with an audit of your R&D credit, as well as protect your tax preparer from penalties for signing a tax return which includes erroneous R&D credits, we recommend that each taxpayer claiming an R&D credit has a study performed by experts to ensure that the claim made is properly calculated and documented appropriately. Depending on the complexity involved, the R&D credit claim may require interviews, documentation and a report substantiating the validity of the credit claim. And it is of paramount importance to understand that an R&D credit study is not a “Get Out of Jail Free Card.” As the IRS stated, “Taxpayers should carefully review reports or studies prepared by third parties to ensure they accurately reflect the taxpayer’s activities. Third parties that are involved in the improper claims or research credit studies also may be subject to penalties.” Too often, taxpayers fall victim to unscrupulous “consultants” who over promise on what an R&D study can achieve for them. It is critical that taxpayers work closely with their consultants to make sure the facts in a study are accurate.
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